Inflation will ensure a higher cost of capital this year, but commercial real estate remains the best inflation resistant investment vehicle.
It’s officially happening. Interest rates are moving up.
After years of quantitative easing, inflationary pressures have forced the Federal Reserve to reverse course. According to a CPI report from December, consumer prices increased 7% last year, and on March 15, the Fed responded with a 25 basis point increase of the Fed Funds Rate, the first of what is likely to be several rate increases this year. “The Fed’s decision to double its tapering pace to $30 billion is clearly a response to the flood of historic inflation data. Inflation holds significant influence over the Fed’s policy tools,” says Gregory Kavoklis, senior associate of capital markets at Matthews Real Estate Investment Services.
To combat inflation, the Fed is going to use all of the tools at its disposal. “In addition to rate increases, the Fed unwinding its balance sheet will put pressure on long-term interest rates. This is going to result in higher borrowing costs,” says Kavoklis.
The trend is already happening. In the last 12 months, the 10-Year Treasury yield increased .7%. “As the treasury yields and swaps move up, I am seeing lenders in the marketplace adjust their pricing accordingly,” says Kavoklis. “The ability to stretch loan dollars on purchases and the amount of equity being returned to sponsors on refinance executions will be reduced as rates continue to trend upward.”
Rising interest rates will make deals more challenging, but the rate jump is coming when commercial real estate fundamentals are tremendously strong, particularly in multifamily, which is benefitting from a supply-demand imbalance and material and labor shortages that have increased the barriers to building new supply. “This really highlights commercial real estate’s resistance to inflation as an asset class,” says Kavoklis. “These factors will keep commercial real estate investment attractive, despite the increased cost of capital.”
While Kavoklis unequivocally expects rates to increase this year, he says that by historical standards, rates will remain low. “My expectations for this year are that rates are going to continue trending upward, but remember that rates have been trending downward for the last 30 years or so,” he explains. “So, even though we are coming up off of the floor of interest rates in the last two years, rates remain historically low.”
His one piece of advice: choose the right team to navigate these new waters. Kavoklis recommends working with a capital markets team that can leverage a deep well of professional contacts to ensure that borrowers are securing the best terms. As he explains, “As rates continue to rise, retaining and aligning with qualified financial intermediaries will remain critical to identifying lenders in the marketplace who are providing the lowest cost of capital to win deals.”